November 18, 2011

Margin Accounts: Rules for Calculating Margins on Leveraged ETF's and Impact on Day Trading Buying Power

Part I - A Quick Primer on Margin

Introduction

Margin means a person borrows money from the person's broker to purchase securities.

Buying with borrowed money can be extremely risky because both gains and losses are amplified. That is, while the potential for greater profit exists, this comes at price - the potential for greater losses. However, properly used, margin can be a very valuable tool in the arsenal of a sophisticated investor.

Margin is not static. Margin is based on an investor's equity in a position. So as a position moves against an investor the amount of capital the investor must have available in the account to meet the margin requirement increases. Conversely, as a position moves in favor of an investor, capital the investor has available in the account to meet the margin requirement increases freeing it for investment in other positions.

Margin Example 1 - Decrease in Value

Assuming a 50% margin (this is not the rate for ETF's) a person would have $50,000 equity and $50,000 debit in a $100,000 long position. If the value of the position declined to $90,000 the person's equity would be only $40,000 and the person would have to put up, or have available in the account, an additional $5,000 to maintain the position. This is essentially known as a margin call. If this margin call was not timely met then the broker would sell from the position to the extent needed to raise the additional $5,000.

Margin Example 2 - Increase in Value

Assume the same facts except the value of the position increases to $110,000. Now the person has $60,000 of equity which is $5,000 in excess of what the person needs to maintain the position. The $5,000 excess is available to invest in other positions.

Interest on Margin Accounts

In addition, the broker will charge interest on the debit amount in a margin account. At the date of posting of this article starting effective margin rates on smaller retail debit balances were around 8.5% to 9%,

Part II - ETF Margin Requirements (Basic)

ETFs are typically registered unit investment trusts (UITs) or open-end investment companies whose shares represent an interest in a portfolio of securities that track an underlying benchmark or index. However, some ETFs that invest in commodities, currencies, or commodity—or currency—based instruments are not registered as investment companies. Unlike traditional UITs or mutual funds, shares of ETFs typically trade throughout the day on an exchange at prices established by the market.

A few years ago margin calculation for most ETF positions in margin accounts was straightforward: 25% maintenance margin requirement on long ETF's and 30% on short ETF's was the standard.

However, effective December 1, 2009, on leveraged ETF's, the calculation became more complex.

Because ETF leverage means 2 times or 3 times the move of the underlying, the margin on leverged ETF is now (since 2009) based on the degree of leverage. The maintenance level of 25% for longs grows by the 2x or 3x mutiples. The same for shorts except the "base" level is 30%. Nonetheless, the margin requirement will not exceed 100% of the value of the ETF in any circumstances.

Here are the current rules:

2x LongIf a person buys shares of a 2x ETF on margin, the old maintenance requirement was 25%. Under current rules, this went up to 50%, or twice the old level (25% x 2).

The action increasing the margin requirement, was a response to the greater exposure associated with leverage. The Financial Industry Regulatory Authority (FINRA) explained, "FINRA believes higher margin levels are necessary.”

The FINRA rules also deal with margins on options on leveraged ETF's as well as the impact of leveraged ET's on day trading power of an account.

Part III - Margin on Options on ETF's

FINRA also increased the maintenance margin requirements for listed and over-the- counter uncovered options on leveraged ETFs in a similar fashion. Prior to December 1, 2009, the maintenancemargin requirement for a listed, uncovered option overlying an ETF on a broad-based index or benchmark was:

100% of the option premium;

plus 15% of the ETF market value;

minus any out-of-the-money amount;

subject to a minimumrequirement of:

100% of the option premiumplus 10% of the ETF market value for call options; and

100% of the option premiumplus 10% of the exercise amount for put options.

For a listed, uncovered option overlying an ETF on a narrow-based index or benchmark,the percentage of the ETF market value was 20%.

For a listed, uncovered option on a leveraged ETF, the formula above continued toapply; however, the percentages of the underlying ETFmarket value were to be determinedusing the same methodology as the underlying ETF. Thus, instead of using 15% of theETF market value for a broad-based ETF and 20% for a narrow-based ETF, a leveragedETF at 200% had to and has to now use 30% (two times 15%,or 40% for narrow-based) of the marketvalue, and a leveraged ETF at 300% had to and has to now use 45% (three times 15%, or 60% fornarrow-based).

Part IV - Efect of Leveraged ETF's on Day Trading Buying Power

For day-trading purposes, the calculations to determine day-trading buying powerand day-trade calls also became based on the amount of leverage on the ETF with effect at December 1, 2009. Thus, the day-trading buying power on a leveraged ETF needed to and need to include the higher margin requirements described above.

The following example should help demonstrate the calculation of day-trading buyingpower as it relates to a leveraged ETF: Customer A has a total, long market value, based on the previous nights’ close of business, of $100,000. The market value is composed entirely of long positions in a 300% leveraged ETF. The customer is carrying a margin debit balance of $20,000. The day-trading buying power is computed as follows:

Nothing is this blog is intended to be or may be relied upon as specific legal advice. Securities and related laws are complex and facts are different from case to case. Competent counsel should be consulted. Views expressed by the author in this article are his own and not those of any other person.

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Margin Accounts: Rules for Calculating Margins on Leveraged ETF's and Impact on Day Trading Buying Power

Part I - A Quick Primer on Margin

Introduction

Margin means a person borrows money from the person's broker to purchase securities.

Buying with borrowed money can be extremely risky because both gains and losses are amplified. That is, while the potential for greater profit exists, this comes at price - the potential for greater losses. However, properly used, margin can be a very valuable tool in the arsenal of a sophisticated investor.

Margin is not static. Margin is based on an investor's equity in a position. So as a position moves against an investor the amount of capital the investor must have available in the account to meet the margin requirement increases. Conversely, as a position moves in favor of an investor, capital the investor has available in the account to meet the margin requirement increases freeing it for investment in other positions.

Margin Example 1 - Decrease in Value

Assuming a 50% margin (this is not the rate for ETF's) a person would have $50,000 equity and $50,000 debit in a $100,000 long position. If the value of the position declined to $90,000 the person's equity would be only $40,000 and the person would have to put up, or have available in the account, an additional $5,000 to maintain the position. This is essentially known as a margin call. If this margin call was not timely met then the broker would sell from the position to the extent needed to raise the additional $5,000.

Margin Example 2 - Increase in Value

Assume the same facts except the value of the position increases to $110,000. Now the person has $60,000 of equity which is $5,000 in excess of what the person needs to maintain the position. The $5,000 excess is available to invest in other positions.

Interest on Margin Accounts

In addition, the broker will charge interest on the debit amount in a margin account. At the date of posting of this article starting effective margin rates on smaller retail debit balances were around 8.5% to 9%,

Part II - ETF Margin Requirements (Basic)

ETFs are typically registered unit investment trusts (UITs) or open-end investment companies whose shares represent an interest in a portfolio of securities that track an underlying benchmark or index. However, some ETFs that invest in commodities, currencies, or commodity—or currency—based instruments are not registered as investment companies. Unlike traditional UITs or mutual funds, shares of ETFs typically trade throughout the day on an exchange at prices established by the market.

A few years ago margin calculation for most ETF positions in margin accounts was straightforward: 25% maintenance margin requirement on long ETF's and 30% on short ETF's was the standard.

However, effective December 1, 2009, on leveraged ETF's, the calculation became more complex.

Because ETF leverage means 2 times or 3 times the move of the underlying, the margin on leverged ETF is now (since 2009) based on the degree of leverage. The maintenance level of 25% for longs grows by the 2x or 3x mutiples. The same for shorts except the "base" level is 30%. Nonetheless, the margin requirement will not exceed 100% of the value of the ETF in any circumstances.

Here are the current rules:

2x LongIf a person buys shares of a 2x ETF on margin, the old maintenance requirement was 25%. Under current rules, this went up to 50%, or twice the old level (25% x 2).

The action increasing the margin requirement, was a response to the greater exposure associated with leverage. The Financial Industry Regulatory Authority (FINRA) explained, "FINRA believes higher margin levels are necessary.”

The FINRA rules also deal with margins on options on leveraged ETF's as well as the impact of leveraged ET's on day trading power of an account.

Part III - Margin on Options on ETF's

FINRA also increased the maintenance margin requirements for listed and over-the- counter uncovered options on leveraged ETFs in a similar fashion. Prior to December 1, 2009, the maintenancemargin requirement for a listed, uncovered option overlying an ETF on a broad-based index or benchmark was:

100% of the option premium;

plus 15% of the ETF market value;

minus any out-of-the-money amount;

subject to a minimumrequirement of:

100% of the option premiumplus 10% of the ETF market value for call options; and

100% of the option premiumplus 10% of the exercise amount for put options.

For a listed, uncovered option overlying an ETF on a narrow-based index or benchmark,the percentage of the ETF market value was 20%.

For a listed, uncovered option on a leveraged ETF, the formula above continued toapply; however, the percentages of the underlying ETFmarket value were to be determinedusing the same methodology as the underlying ETF. Thus, instead of using 15% of theETF market value for a broad-based ETF and 20% for a narrow-based ETF, a leveragedETF at 200% had to and has to now use 30% (two times 15%,or 40% for narrow-based) of the marketvalue, and a leveraged ETF at 300% had to and has to now use 45% (three times 15%, or 60% fornarrow-based).

Part IV - Efect of Leveraged ETF's on Day Trading Buying Power

For day-trading purposes, the calculations to determine day-trading buying powerand day-trade calls also became based on the amount of leverage on the ETF with effect at December 1, 2009. Thus, the day-trading buying power on a leveraged ETF needed to and need to include the higher margin requirements described above.

The following example should help demonstrate the calculation of day-trading buyingpower as it relates to a leveraged ETF: Customer A has a total, long market value, based on the previous nights’ close of business, of $100,000. The market value is composed entirely of long positions in a 300% leveraged ETF. The customer is carrying a margin debit balance of $20,000. The day-trading buying power is computed as follows:

Nothing is this blog is intended to be or may be relied upon as specific legal advice. Securities and related laws are complex and facts are different from case to case. Competent counsel should be consulted. Views expressed by the author in this article are his own and not those of any other person.